How GlaxoSmithKline missed red flags in China

A Chinese national flag is seen in front of a GlaxoSmithKline office building in Shanghai, July 12, 2013.

Reuters/Aly Song

LONDON (Reuters) - With more compliance officers in China than in any country bar the United States, British drug maker GlaxoSmithKline Plc seemed well-positioned to do things right.

But despite conducting up to 20 internal audits in China a year, including an extensive 4-month probe earlier in 2013, GSK bosses were blindsided by police allegations of massive corruption involving travel agencies used to funnel bribes to doctors and officials.

The scale of funds signed off by GSK to pay travel agencies for organizing educational medical meetings has triggered heated debate, with some saying such spending would have looked legitimate but others arguing it should have raised alarms inside GSK and at its external auditor PricewaterhouseCoopers.

GSK, which has described the allegations as "shameful", has declined to comment on specific shortcomings in internal procedures. PwC declined to comment on the case, citing client confidentiality.

Britain's biggest drug maker, which has some 7,000 staff in China, has now hired Ernst & Young to conduct an independent review of its systems in China, as well as sending top-level executives to see how an alleged web of bribery worth up to 3 billion yuan ($489 million) was missed.

One possible reason, according to consultants who have worked for GSK as well as current and former employees, likely lies in both the care with which payments were kept off GSK's books and the senior level of the Chinese managers involved.

As the alleged bribes went through the accounts of the travel agencies, rather than GSK, and many of the individual amounts may not have been material, the issue was unlikely to have been picked up by auditors or head office, some accountancy experts maintain.

"You'd look at invoices and expenses, and it would all look legitimate," said a senior executive at one top accountancy firm. "The problem with fraud - if it is good fraud - is it is well hidden, and when there is collusion high up then it is very difficult to detect."

The failure comes despite GSK carrying out as many as 20 internal audits annually within different areas of its Chinese business, each of which typically uncovers around five employees infringing processes in some way, one source familiar with the matter said.

MEDICAL EDUCATION OR BRIBE?

Four senior Chinese executives from GSK have been detained by police, including vice president and operations manager Liang Hong, who told Chinese state television how he channeled money through travel agencies by arranging medical conferences, some of which were never held.

Continuing medical education (CME) has long been a major area of investment for drug companies as they seek to encourage doctors to use their products by taking them to meetings where the latest advances in medicine are discussed.

In the United States and western Europe, such CME funding for doctors is now tightly controlled. But there is little oversight in emerging markets.

Industry experts say the GSK case shows the hazards facing pharmaceutical companies in China, where a culture of giving gifts is deep-rooted and doctors rely on payments for prescribing drugs to supplement their meager incomes.

That makes China a particularly tricky jurisdiction in which to impose head-office ethics, according to Lincoln Tsang, a partner at the London offices of law firm Arnold & Porter.

China is also probing potential malpractice at other firms, with Belgium drug maker UCB visited by Chinese authorities this week.

GSK says its global code of conduct applies just as much in China as anywhere else and it has zero tolerance of bribery.

Getting the internal audits rights is not straightforward for multinational companies - especially if high-up individuals, who auditors expect to be onside, turn out to be involved in the conspiracy because that is the local culture.

"There is a disconnect between the global decision makers and the guys running things on the ground," said Jeremy Gordon, director of China Business Services, a risk management company focusing on China.

"It's about initially identifying red flags and then searching for specifics."

TRAVEL AGENCIES "USED LIKE ATMS"

Still, other auditing experts are asking why and whether GSK auditors failed to comb through the Chinese unit's marketing expenses. They say that one red flag was the number of checks being written to travel agencies for sending doctors to medical conferences, although this may have been blurred by the fact that CME accounts for a huge part of drug industry marketing.

Nonetheless, it was an obvious area for suspicion, according Paul Gillis, author of the China Accounting Blog and also a former PwC partner.

"Travel agencies are used like ATMs in China to distribute out illegal payments. Any company that does not have their internal audit department all over travel agency spending is negligent," he said.

On Monday, GSK said it had put an immediate stop on the use of travel agencies identified so far by Chinese investigators and was reviewing all historic transactions.

The official Xinhua news agency said on Thursday that authorities in Shanghai had suspended the business of the Shanghai Linjiang International Travel Agency, one of the businesses linked to GSK.

These travel agencies may have been a blind spot for GSK, auditing experts said. Previous charges of corruption that were raised by a whistleblower, and which GSK said earlier this year were without foundation, did not involve agencies.

China currently accounts for just 3.5 percent of GSK drug sales but demand is growing fast - up 17 percent last year - and the company is investing heavily, with more than 7,000 staff in China, as well as five factories and a research center.

In the wake of the scandal, analysts at Berenberg bank said GSK was likely to have to implement a disruptive overhaul of its Chinese commercial organization.